rule rationality act rationality
TRANSCRIPT
Rule Rationalityvs.
Act RationalityAct Rationality
Bob Aumann
Center for the Study of RationalityThe Hebrew University, Jerusalem
The 2002 Economics Nobel PrizeThe 2002 Economics Nobel Prizewas awarded toDaniel KahnemanandandVernon Smith.
Kahneman showed that people are irrational.p pSmith showed that people are rational.
What’s going on?
KahnemanKahneman
• “In extensive research on human behavior based on surveys and experiments, … Kahneman …called into question the assumption of economic rationality. … (He showed) that people are incapable of fully analyzing complex decision situations … they rely instead on heuristic shortcuts and rules of thumb.”
– Information for the Publicwww.nobelprize.org/nobel_prizes/economics/laureates/2002/popular.htmlp g _p p p
SmithSmith
• “The first experiments in economics … (tested) … the most fundamental result in economic theory: … (that) the market price (equilibrates) between supply and demand. … Smith found, much to his surprise, that the prices obtained in the laboratory were very close to their theoretical values. … other researchers … by and large confirmed the results.”
– Information for the Publicwww.nobelprize.org/nobel prizes/economics/laureates/2002/popular.htmlwww.nobelprize.org/nobel_prizes/economics/laureates/2002/popular.html
So what indeed is going on?So, what indeed is going on?
Kahneman and Tversky themselves give the answer: People use “heuristics” – rules of thumb; they do p ; y
not consciously maximize. In their pioneering 1974 paper, they write:p p , y
“In general (these heuristics) are quite useful butIn general, (these heuristics) are quite useful, butsometimes they lead to severe and systematicerrors.”
-- D. Kahneman and A. Tversky (Science, 1974)
In briefIn brief,
• Smith relates to the usual, the rule, the “in general;”• Kahneman – to the unusual, the exception, the p
“sometimes.”
• And,
• they’re both right!y g
But what was the Nobel committee up to?But, what was the Nobel committee up to?
They awarded the prize not, as usual, for findings, but for a methodology:g , gy
L b t i t dLaboratory experiments – and surveys or polls – in economics.
Georg HEGEL (1807)g ( )
Cl i l E iThesis: Classical Economics: RationalityRationality
Antithesis: Behavioral Economics:Systematic Irrationality
Rule RationalitySynthesis: Rule-Rationality
Act Rationality:Maximize over acts – in each decision situation, choose an act that’s best in that situationchoose an act that s best in that situation.
Rule Rationality:Maximize over rules--in each kind of decisionMaximize over rules in each kind of decisionsituation, choose a rule that’s best on the whole,or s all b t not necessaril al a sor usually, but not necessarily always.
Act Rationality - deliberate, conscious.
Rule Rationality - evolutionary learnedRule Rationality - evolutionary, learned, subconscious.
Often, the rule is executed by means of amechanism.
a. Bees, flowers, and nectara. Bees, flowers, and nectar••••••••••••••• IRRATIONAL••••••••••
(Andreas Bertch, circa 1985, unpublished)•••••
Q: Actually, why would you expect rationalityfrom a bee?
A: EVOLUTION – survival of the fittest
b. The Ultimatum Gameb. The Ultimatum Game(Güth et al, 1982, Roth et al 1991, Roth and Slonim 1998, …)
Two people must divide $100.-They are in separate rooms, do not know y p ,each other, and interact only this one time.
A designated one, the offerer, makes anoffer The other one the responder mayoffer. The other one, the responder, may either accept or reject. If he accepts, the amount is divided accordingly If not noamount is divided accordingly. If not, no one gets anything.
Results: Usually most offers are 65-35Results: Usually, most offers are 65 35
or more generous, and are accepted.
Some offers are 80-20, and are usually rejected.
This is IRRATIONAL
Possible explanations:
PRIDE, SELF-RESPECT, INSULT, REVENGE.
Irrelevant explanations:
REPUTATIONAL EFFECTS
• BEES & FLOWERSBEES & FLOWERSAct: Find food wherever you canRule: Go by ExperienceMechanism: Learning window
ULTIMATUM GAME• ULTIMATUM GAMEAct: When offered $20, take them.Rule: Don’t let people kick you in the stomach!Rule: Don t let people kick you in the stomach!Mechanisms: PRIDE, SELF-RESPECT, INSULT, REVENGE
Rationality is an expression of evolutionaryforces, which work by the RULE, not theexception, not the contrived situation.
Other Examples:Other Examples:• Hunger & enjoyment of food• Bees & orchids• Bees & orchids• Enjoyment of sex• Arrow’s Pacific Island story• Arrow s Pacific Island story• Probability matching
– Choosing a route to get to work (Dreze)Choosing a route to get to work (Dreze)• Immediacy (Hyperbolic Discounting) (Bavli)• Recency (overweighting the probability of recent events)y ( g g p y )• Professor Selten’s Umbrella• Endowment Effect• Anchoring• Altruism• Conjunction Fallacy (Zilber, Hertwig & Gigerenzer)
The 08 Financial CrisisThe 08 Financial Crisis
• One often hears that this was irrational, that behavioral economics explains it.behavioral economics explains it.
• On the contrary, IMHO the crisis came about b l d d t th i i tibecause people responded to their incentives– i.e., behaved rationally.
• It is the incentives that were at fault.
Immediate Cause: Subprime LendingImmediate Cause: Subprime Lending• Easy borrowing motivated high demand for housingEasy borrowing motivated high demand for housing
• This demand motivated a lot of new constructionThis demand motivated a lot of new construction
• Then defaults created a housing glut motivating a• Then defaults created a housing glut, motivating a steep drop in prices
• Low down payments gave incentives to default
• This drove prices even further down
• The process continues …
Underlying Causes:Underlying Causes:
• Entanglement (credit default swaps) created gmoral hazard
• Incentives for Loan Officers• Incentives for Loan Officers• Incentives for Bank Executives• These led to overly risky behavior, like• Overleveraging• Overleveraging
So it’s all aboutSo, it s all about
I tiIncentives
DP 497 of the Hebrew University Rationality Center:Rationality Center:
http://www.ratio.huji.ac.il/dp files/dp497.pdfp j p_ p p